What will the Cash Flow Look Like on a Typical Investment Home in Austin TX?

by Steve Crossland, REALTOR in Austin TX on July 12, 2006 · 12 comments

I’ve just updated the Investing in Austin page on my website. I wrote it about a year ago and realized it was sorely in need of an update. It now has fresh numbers and charts that more closely match the actual numbers that a lot of our investor buyers are contemplating with the types of Austin investment properties we recommend. I’m posting the cash flow portion of the updated investment page below.

(This is for illustrative purposes only, not a prediction of what you can achieve)

Let’s assume you buy a $225,000 home with a 20% down payment on a 30 year loan at 7%. Let’s say that home will rent for $1,500 per month, or an annual rental income of $18,000 which is 8.0% of your purchase price. Note the other variables in the chart below. Does it make sense for you to invest in real estate in Austin based on these numbers? Let’s look at the chart below.

Sample Investment Preferences
Loan Assumptions Expense Assumptions Income Assumptions
Purchase Price $225,000 Property Tax Rate 2.75% Rent $1500
Downpayment 20% Hazard Insurance 0.5% Occupancy Rate 90%
Interest Rate 7% Management Fee 8% Annual Rent Inflation 3%
Loan Term 30 Years PMI 0% Annual Property Appreciation 8%
Loan Points 1% HOA Fee $30    
Closing Costs 3% Annual Maintenance $1,356    

Let’s review the above info …

Loan Assumptions – this column should be self explanatory.

Expense Assumptions - Property taxes are high in Texas. They will range from around $2.35 up to $3.25 per $100 of fair market valuation of your property. We’ve used a mid-range of 2.75%, which is the current rate in most of the city of Austin. We’ve added a Management Fee, HOA Fee, and an estimated annual repair expense fee to our assumption. You may not have a property manager or an HOA Fee, and your repairs may not be as high as those in our example, but we want to provide you a scenario that is more stark than rosy.

Income Assumptions – We’ve assumed a monthly rent of $1500. Your actual rent could of course be higher or lower. We’ve used a pessimistic vacancy rate of 90% which would assume that over 1 month a year of rental income will be lost to vacancy and leasing fees. We do not think this is too harsh of a vacancy and leasing expense assumption. Of course it’s not unusual for a tenant to remain in a property for several years (we have a tenant who has lived in a rental property we own since 1996), but it will be prudent for you to be conservative in your approach to forecasting rents. We’ve included a reasonable and conservative rent escalation of only 3% per year and a property appreciation rate of 8% per year for illustrative purposes. Some homes we sold less than a year ago have appreciated more than 15% since then, but we of course do not know what your actual experience with rents and value appreciation will be. We think the assumptions in our example are reasonable to use, even if they do scare off a few potential buyers.

A summary of the Purchase numbers is shown in the next chart.

Purchase Data
Price: $225,000
Closing Costs: $6,750
Loan Origination: $2,250
Downpayment $45,000
Total Cash to Close: $54,000
Loan Amount $180,000

Let’s look below at what your monthly cashflow might look like on this property during the first year, given our assumptions.


Monthly Pro Forma (Year One)

Mortgage
(P&I)
$1198
Property Insurance $94
Property Management $108
HOA $30
Maintenance Expense $113
Property Tax $516
Total Monthly Expense $2029
Monthly Rental Revenue $1500
Prorated Vacancy and Leasing Fee $150
Monthly Cash Flow ($679)


Woops! It looks like your going to “lose” over $600 per month on this real estate investment property!
Are we trying to talk you out of investing in rental property in Austin?
Why don’t we use more optimistic numbers?

We do not think rosy investment property return projections form a good basis for sound real estate decisions. Our main goal is to first and foremost make sure you have a clear grasp of the the potential financial implications of investing in Austin real estate. We are contacted by many new investors from out of state who seem unaware of how the numbers will really work once they buy a rental property.

If you aren’t fully prepared to accept the possibility that your investment property might produce negative cash flow such as shown in our example above, (especially during its first few years), you shouldn’t be buying rental property in Austin TX and we shouldn’t be trying to sell you on the idea of doing so.

Now for some better news

But hold on, this is a before-tax and appreciation scenario. Let’s look below at what happens over time and how this plays out after factoring in tax deductions, equity build-up and appreciation, then let’s see if investing makes sense for you.

10 Year Pro Forma
Year Expense Income Cashflow Interest
Paid
Tax Deductions Appreciation Equity Total Benefit
1 $24,345 $16,200 ($8,145) $12,542 $38,528 $18,000 $1,828 $11,683
2 $24,413 $16,686 ($7,727) $12,409 $29,046 $20,995 $1,960 $15,228
3 $24,484 $17,186 ($7,298) $12,268 $28,547 $24,488 $2,102 $19,292
4 $24,557 $17,701 ($6,856) $12,116 $28,026 $28,563 $2,254 $23,961
5 $24,633 $18,232 ($6,401) $11,953 $27,484 $33,316 $2,417 $29,332
6 $24,710 $18,778 ($5,932) $11,778 $26,917 $38,860 $2,592 $35,520
7 $24,790 $19,341 ($5,449) $11,591 $26,327 $45,326 $2,779 $42,656
8 $24,872 $19,921 ($4,951) $11,390 $25,710 $52,869 $2,980 $50,898
9 $24,957 $20,518 ($4,439) $11,174 $25,067 $61,666 $3,195 $60,422
10 $25,044 $21,133 ($3,911) $10,943 $24,395 $71,927 $3,426 $71,442
Totals $246,805 $185,696 ($61,109) $118,164 $396,010 $25,533 $360,434
* These numbers are examples only and not a prediction of your outcome


So what’s going on in this chart above? Essentially, over time your negative cashflow is offset by tax advantages, equity build-up, and appreciation in the value of your rental property. The illustrations above are not perfect of course and are offered merely as an example of what a possible scenario might look like. Many investors opt for different loan products and are obtaining better interest rates that the 7% we use in our example. Many investors are renting the homes for more than our example assumes, and have less in other costs than our assumption shows.

But again, it is the less optimistic scenario that you must be prepared to accept as an investor, not the most optimistic one.

The bottom line, in our opinion, is that Austin investors who can afford larger down payments, higher price ranges, and modest negative monthly cash flow are well positioned to buy Austin real estate and hold on as the Central Texas real estate market continues enjoying healthy value appreciation. Our rents are still down 20% to 35% in many areas from the rent rates we were obtaining in the year 2001, as you can see in the 2005 Rental Summary. We believe the vibrant rental market we once enjoyed will return, but that it may be a year or two before it picks up momentum again as we are battling against the surge in inventory caused by new investors buying homes that would normally be owner occupied.

Disclaimer: You should ALWAYS consult with your accountant and attorney before purchasing investment property to learn how that activity might effect your personal financial and legal situation.

{ 12 comments… read them below or add one }

1 Todd July 12, 2006 at 1:57 pm

Steve,

I think “5%” annual property appreciation in your top box should read “8%”

Todd

2 Steve Crossland July 12, 2006 at 3:10 pm

Thanks for catching that Todd – I fixed it.

3 Michael Francis July 13, 2006 at 10:19 am

Steve,

Great information, we discussed your findings in our staff meeting this morning.

Thank you!

Michael

4 bill July 13, 2006 at 7:33 pm

So, basically the TX property tax is killing it. I have friends in Canada who’s goal is to acquire 1 million CAD worth of investment property each year. He usually buys apartment complexes rather than single resident. In his business calculation, negative cashflow is absolutely unacceptable.

5 Norman Richards July 14, 2006 at 7:34 am

This looks like a fairly poor investment property. I think this would only be an interesting property if you can acquire it at a discount and make a decent amount of equity on the buy. Otherwise, the rents just aren’t in line – better suited for an owner occupant who is willing to overpay for a property.

I only own one investment property right now in Austin, and I’ve had no problem making a modest positive cashflow. I’d never have bought it if I expected a negative cashflow. I might accept a modest ($50-$100) negative cashflow under more the more pessamistic assumptions you’ve given if I thought the market was booming and property values (or more importantly, rents) would be increasing . (nowing that if things go well, I’ll be positive)

As a general rule, I’d say a property that is only a good investment IF property values rise dramatically is not an investment property. It is a speculation property. Investment properties should generate some real revenue. If you are smart/lucky, you’ll have good appreciation adding big profits makign an already profitable venture golden.

6 Steve Crossland July 14, 2006 at 7:50 am

Hi Norman,

Whether it is a good investment or not depends on the particular circumstances and financial goals of the individual investor. We have a lot of buyers from California who do 1031 Exchanges. San Diego prices have now dipped, making San Diego the first major California city to see a drop in real estate values. For someone with a lot of equity in a California property, they can either leave it there and watch it shrink, or move it tax free to property(s) in a city with rising values.

Many of these buyers make substantial downpayments and/or are not as concerned with the cash flow as they are preserving and growing their balance sheet wealth.

Yes, it is more speculative than the old days (1990s) when almost any single family home would rent for an amount that would cover carrying costs.

As recently as 1999 we could buy 3 bedroom brick homes in Austin area 10 for $90K that would rent for $950. That same home now costs $140K and still rents for $950, and the taxes and insurance are higher. A brand new buyer today, unless they are able to spend time bird dogging for fixer or desperate sellers, will have a difficult time finding a rental home with the ratios we saw in the 1980s and 1990s.
Steve

7 Norman Richards July 14, 2006 at 4:05 pm

Since this is clearly a speculative deal, your buyer should probably consider one of the more exotic loan deals. You could cut your payment by $200 going interest only. ($300 if he’s buys a point as in your scenario above) If you are speculating on rising values, why not go with a speculative loan? You could cut your monthly deficit down significantly. Better yet – why not just go with a some sort of payment option arm deal? That would definitely get the payments down low from the start. That would give you several years for underlying property values to increase. I’m a 15-year fixed find of guy myself, but if you are going to speculate, you might as well do it in style.

For your San Diego buyer – one would hope they would have enough equity there to come in for more than 20% if they really want properties that don’t cash flow. So, maybe in that case it would be ok. They’d just be investing more per property.

But, what do I know?

8 Todd July 16, 2006 at 7:52 am

Thanks to all for an interesting and very pertinent discussion of single-family investment properties. Let me pose a question to those who would “never” buy a property unless it cashflows. I live in an east coast market where no properties come close on a cashflow basis (and have not for over 3 years). I believe many markets on the east and west coast present the same challenge. Yet these markets have made excellent appreciation investments even when initially purchased 5 years ago on a closer to even, but still negative cashflow basis. There are many investors from these markets who wish to invest in real estate, and are willing to make an educated judgment that undervalued Texas markets relative to median income offer similar opportunities to those which existed in CA and the mid-atlantic 4-5 years ago. I think the line between “investment” and “speculation” is a bit more grey than some would state on a bright-line basis.

A second major issue are option and IO loans. Now that buyers can step into a $200,000 loan and pay sub-$1,000 monthly payments, they have little reason to be renters unless they are truly transient. With the further ability to finance 95% + with closing costs, the previous pool of renters is greatly diminished, hence stagnant rental rates vs. rising property values. Even with ARM’s, the current ability to convert to a 30 year under 7% ought to bail most owners out in the short term.

In this environment, I am skeptical of “normal” rental investment returns, ex-cap appreciation in the short term, and am watching with great interest as the coastal markets “deflate” a bit and how this impacts coastal investor owners who have moved into the Texas markets. I think Steve is right on to keep a close eye on rental rate trends. A 20% rise in Austin rental rates over the next 2-3 years would clearly do wonders for the economics of rentals. Question is, do you buy now in anticipation of rental rates firming in addition to anticipating steady capial appreciation from a linear market such as Austin. Or if you wait on rents to firm, will you also end up paying up for properties if you wait on rents to buy?

9 Steve Crossland July 16, 2006 at 3:51 pm

Thanks Todd. Well said.
Steve

10 Jeff July 29, 2006 at 12:53 pm

Interesting discussion. I’d be interested in seeing your itemized breakdown on the tax deductions column in the table above. My calculations are coming up short of your numbers.

11 Steve Crossland July 29, 2006 at 2:53 pm

Jeff,

In the first year, tax deductions would include:
Loan Origination (Points), Closing Cost, Depreciation, Interest Expense, Management Fee, Maintenance, Profit/Loss.

Following years don’t have the Loan fees or closing costs.

I used the calculator at:
http://www.cashflowproperty.net/free/property_detail_custom.asp
to help come up with the numbers. You can enter your own numbers there and check it out.
(Note: I don’t endorse the websiite, I just found the calculator to be useful)

12 Andrew Ao August 16, 2006 at 9:38 am

rite on, steve. i’ve been reading your blog for a while, and find your insight of austin real estate market informative and beneficial.

investing in real estate is always a balance of current cashflow and future appreciation. u r one of the folks whom i met would focus on future appreciation when determining roi. while you speculateon future appreciation, those who focus on cashflow are speculating FUTURE RENTAL INCOME. both are speculation, i believe.

getting back to this articule. i have a few questions on your assumption. you use 3% on rent increase and 8% on appreciation. i m curious if you could provide any justification. long time inflation would be more or less 3-5% unless the government indebtness (esp medicare), is getting out of hand. i feel very comfortable with the 3% increase in rent. but i m not quite sure on the 8% of appreciation. In recent years, we see an asset class inflation. some people see it as a consequence of global saving glut. some would see it otherwise. but the point is that 8% would not be sustainable long term.

just minor technical point on the calculation. should you use discount cashflow to get a more accurate picture? it doesn’t matter much conceptually, but using DCF would definitely lower the ROI.

footnote: i live in CA, but have never set my foot on TX yet. so, i ain’t as knowledgeable about the conditions in TX.

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